Despite the wealth of talent and ability vested in the South African investment banking arena, BEE transactions continue to be funded using inefficient, ineffective, even hackneyed mechanisms.
Possibly one of the worst examples of this is the ongoing use of preference shares to fund transactions. In the preference share scenario, a company sells a portion of its shares to a potential BEE partner who, in turn, funds the purchase of these shares by issuing preference shares either in itself or in a special purpose vehicle. For a number of reasons this is an expensive route to go in the current economic and business environment.
Firstly, in terms of Section 38 of the Companies Act, companies are prohibited from providing financial assistance to any party wishing to buy their shares. The Section 38 constraint typically causes the preference shares issued by the BEE partner to be secured through complex control and security mechanisms which achieves very little and in many instances merely increases the cost of finance.
Thus, in comparison to debt, preference shares have become a relatively expensive method of finance due to the security, risk and tax inefficiencies associated with them.
Tax cost
In the current environment, preference shares would typically cost anything north of 80% of prime, which equates to a cost of funding of 8.8%. In addition, secondary tax on companies (STC) would apply which adds a further 1.1%, taking the cost of funding to 9.9%. Then, in addition, when the BEE partner ultimately realises its shares in the company it will have to pay capital gains tax on any profits without tax relief on the funding cost (preference share dividends).
On the other hand, if the transaction had been funded through the use of debt, some or all of the interest costs would be deductible for CGT purposes against the eventual capital gain. This would further increase the comparative cost of funding using preference shares to 11.65%.
Market risk
In addition, the asset securing the funding in a preference share-based transaction is subject to the vagaries of the stock market. Thus, when the market performs, the financier can fare extremely well. But during a bear market the financier is exposed to falling shares prices and runs the risk of not being able to recover the funding it provided. By definition, the market volatility in the underlying asset being financed further increases the cost of funding.
If the transaction is funded through debt directly against the underlying assets and cash flows, it provides the financier with a vastly improved risk profile which translates into a lower risk asset on its balance sheet thereby enabling it to fund the transaction at a lower, reduced rate. To the extent that the financier is directly funding the assets as opposed to the shares, it has access to the cash flow on the assets as opposed to a share price which may or may not increase over time. When lending against assets, the financier is only exposed to the risk of the company doing well, and not to the risk of the stock market underperforming.
Given these factors, BEE transactions should probably be funded against the assets and not against the equity investment of the BEE partner.
BEE codes
A new problem that has arisen with the funding of equity with both preference shares and debt is that funding of any sort reduces the level of recognition that companies wanting a BEE partner can achieve on the BEE scorecard. This is due to the new Codes of Good Practice, published by the Department of Trade and Industry, which provide that when company shares are held by a BEE partner, and those shares are funded by any form of debt, they are treated as restricted shares. The consequence of that would be that the company would only receive 60% of the points available to it under the BEE Scorecard.
Finally, by their very nature preference shares are a relatively short-term funding instrument, typically between three and five years. If the share price of the company does not perform, at the end of five years the empowerment partner would have no stake in it and the company would have to re-empower itself with a new partner all over again. Debt finance raised against the underlying assets, on the other hand, can typically be structured on a longer-term funding basis which locks the BEE partner in for a longer period of time and thereby makes the empowerment transaction more sustainable.
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